The IRS has released proposed guidance on required minimum distributions (RMDs) from inherited IRAs.
I’m going to talk about details of how the new guidance could affect an IRA you have inherited or your own IRA when you leave it to your heirs.
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As you may remember, under the SECURE Act, which went into effect January 1, 2020, inherited IRA assets must be withdrawn by most beneficiaries within 10 years of inheritance, and all ordinary income taxes would be due at the time of the distribution.
This provision requires some planning for people who have larger IRAs, because their heirs will often be required to take out the full amount during their peak earning years.
Beneficiaries that are Not Affected
This does not apply to spousal beneficiaries, who can still stretch payments over their lifespan.
This also doesn’t apply to certain eligible beneficiaries, including an individual not more than 10 years younger than the IRA owner (often a sibling) and a disabled or chronically ill individual (as defined by the IRS). These beneficiaries can still take distributions over their lifetime following the old rules prior to the SECURE Act.
In addition, the 10-year withdrawal period for a minor child of the IRA owner can be delayed up to age 21.
New IRS Guidance
The biggest thing I want you to take away today, is what will apply to all other named beneficiaries. Most often this will apply to situations where an IRA owner’s adult children are the primary beneficiaries.
At the time the SECURE Act was signed into law, there was no guidance as to how those payments had to be withdrawn during the 10 years after inheritance.
Prior to this IRS guidance, many financial experts believed no RMDs would be required until year 10, when the full balance must be withdrawn.
Now, proposed guidance from the IRS suggests that if the account holder dies after the required beginning date for RMDs, which is generally April 1 of the year following the year the IRA owner turned 72, the beneficiaries would be required to withdraw RMDs in years one through nine.
Then the remaining balance would have to be withdrawn in year ten.
This is not a rule yet, but we want to think about it now because it looks like this will likely be the IRS interpretation and it will be applied retroactively.
This means if someone inherited an IRA in 2020, they may have already missed their RMD for 2021. And the penalty for missing an RMD is steep – 50% of the amount that should have been withdrawn.
However, I am not suggesting making up the missed payment at this time. The IRS may offer additional guidance later this year and could provide a waiver of penalties.
Situations where RMDs would Not be Required
If the IRA owner died before being required to take RMDs, the beneficiaries would not be required to take RMDs and would simply have to withdraw the entire account by year 10.
Roth IRAs are also subject to the 10-year rule; however, since Roth IRAs are never subject to lifetime RMDs, the beneficiary is not required to take an RMD until year 10 when the entire account must be withdrawn. This allows the Roth IRA funds to continue to grow tax-free during those 10 years.
This 10-year rule under the SECURE Act only applies to IRA owners who died after December 31, 2019. The prior stretch rules are grand-fathered in for IRA assets inherited prior to the SECURE Act.
There are a couple of options to consider if you have large tax-deferred retirement accounts.
If you are married, instead of leaving your entire IRA to your spouse, you could name your kids as additional primary beneficiaries to receive 20-30% instead of leaving all 100% to your spouse.
This could relieve some of the tax burden on your children by giving them some money earlier.
If you live in a community property state, your spouse would need to sign off on this beneficiary change for IRAs.
Most defined-contribution retirement plans, such as 401(k) and 403(b) plans, also require a witnessed spousal signature to name a primary beneficiary other than your spouse.
You could also consider the possibility of doing partial Roth conversions now by moving some of the traditional IRA assets into a Roth IRA and paying taxes at today’s low rates.
For the person inheriting a Roth IRA, all distributions are tax-free.
An important takeaway from this new regulation is that you should always name your beneficiaries, and review your beneficiaries annually to make sure they reflect what you want to see for your legacy.
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